Resource Conversion

Resource Conversion

          One exercise we go through on all our most interesting ideas is what we call balance-sheet optimization. It’s our term for debt recap. What can management do, fully under its control, with the capital structure to create value? Use Microsoft as an example. It has $60 billion of cash on hand, very little debt and throws off something like $30 billion in free cash flow per year. The equity has been trading at 8 to 10 times earnings and the company can issue debt at less than 3.5%, so there’s a huge difference between the cost of debt and the cost of equity. As an exercise, what would happen if it went to a net $60 billion debt position? Given the free cash flow, that’s still a modest capital structure. They take the $120 billion in cash proceeds and buy back a significant amount of their equity. With a lowered cost of capital and shares outstanding cut in half, if we run that through our cash-flow model – assuming no growth – we come up with a share value in the low to mid $40s, versus around $28 today.

          We look at this as our downside protection and also as a way to distinguish our analysis. It’s difficult to out-predict the Street consistently on Microsoft’s growth over the next five years, but very few analysts focus on value creation through the capital structure, so it can provide us with a different perspective on how to value the stock.

         

          Stephen Goddard, The London Company

Welcome to the world of corporate events. I was introduced to this world by reading Marty Whitman, the founder of Third Avenue Management. He wrote that there are more ways to create shareholder value other than focusing on the operational side of a company. In other words everything you have read so far in this blog pertains to the company as an ongoing concern. According to Whitman a company can create value through corporate restructuring by engaging in mergers, acquisitions, spinoffs, buyouts, recapitalizations, liquidations, changes of control, and other activities that generate wealth by putting a companies resources to other uses.

Now this is all fascinating stuff for sure but unfortunately Whitman can’t write to save his life. Reading him for the first time was a somewhat dirge-like experience but what he writes about is so important you should make the effort to familiarize yourself with him. Luckily for me along came Joel Greenblatt with his ‘You Can Be a Stock Market Genius’, a truly great book on investing in the stock market. What Whitman described as resource conversion Greenblatt referred to as corporate events. If you choose to investigate this area of investing I suggest you start with Greenblatt’s book. It’s a much easier and fun read. After I read Greenblatt’s book I went back and tried to read Whitman again.

Under this approach the quality and quantity of a companies assets, become an important factor both in valuing the company along with considering its growth prospects. This is especially important when dealing with larger more established companies.

To gain insight into valuing this type of company an investor must look beyond the company as an ongoing concern (operational earnings) and consider the potential of a company redeploying its assets in mergers, acquisitions, spinoffs and liquidations. A company can also act as financiers when they decide to go private, incur debt and distribute cash to their shareholders.

Consider Brookfield Asset Management as an example how a company can manage its assets to enhance shareholder return…

They obtain equity from clients looking to invest in real assets, then use the company’s global reach to acquire distressed but high quality assets. They do this when capital is scarce and the assets they seek are generally on the market below their replacement value. They then finance those assets on a long-term and low-risk basis. They further enhance the cash flows and values of those assets through their leading operating platforms.

Needless to say I own several of Brookfield’s subsiduaries.